OM FINAL

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

CHAPTER SEVEN: DIVIDEND POLICY

Yi Zhou

Associate Professor Department of Finance

College of Business San Francisco State University

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

DIVIDENDS ARE IRRELEVANT

In Miller and Modigliani’s (MM) world with no taxes, no transaction costs, and homogeneous information, dividend policy does not affect the value of the company.

The decision of how a company finances its business is separate from the decision of what and how much to invest in capital projects.

If an investor wants cash flow, he/she could sell some shares.

If an investor wants more risk, he/she could borrow to invest.

An investor is indifferent about a share repurchase or a dividend.

Dividend policy does not affect a firm’s value.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

THE BIRD-IN-THE-HAND ARGUMENT

Investors prefer a cash dividend to uncertain capital gains. Investors prefer the “bird in the hand".

If this explanation holds, a company that pays a cash dividend will have a higher value than a similar company that does not pay a cash dividend.

Dividend policy affects the value of the firm.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

THE TAX ARGUMENT

If dividends are taxed at a rate higher than capital gains, investors prefer capital gains.

When dividends are taxed at a rate higher than that of capital gains, this advocates a zero dividend payout.

Dividend policy affects the value of the firm.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

THE CLIENTELE EFFECT

The clientele effect is the influence of groups of investors attracted to companies with specific dividend policies. Clientele are simply a group of investors who have the same preference.

If an investor has a marginal tax on capital gains lower than the marginal tax on dividends, the investor prefers capital gains.

Investors who are tax exempt are indifferent about dividends and capital gains.

The importance of the existence of clientele is that investors will have a preference for stocks with a specific dividend policy.

The clientele effect does not necessarily imply that dividends affect value.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

DIVIDENDS AND SIGNALING

Under MM’s theory, everyone has the same information.

When there is asymmetric information, dividend changes may convey information.

Positive Information: Dividend initiations and increases.

Negative Information: Dividend omissions and reductions.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY DIVIDENDS ARE IRRELEVANT THE BIRD-IN-THE-HAND ARGUMENT THE TAX ARGUMENT THE CLIENTELE EFFECT DIVIDENDS AND SIGNALING AGENCY COSTS AND DIVIDEND POLICY

AGENCY COSTS AND DIVIDEND POLICY

The separation of ownership and management in a corporation may lead to suboptimal investment. Management may invest in negative NPV projects to enhance the company’s size or management’s control.

Jensen’s free cash flow hypothesis is that having free cash flow tempts management to make investments that are not positive NPV. Paying dividends or interest on debt uses this free cash flow and averts an agency issue.

Dividends may reduce agency costs and, therefore, increase the value of the firm.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY FACTORS AFFECTING DIVIDEND POLICY

FACTORS AFFECTING DIVIDEND POLICY

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY FACTORS AFFECTING DIVIDEND POLICY

FACTORS AFFECTING DIVIDEND POLICY

More investment opportunities, less dividends.

More expected volatility of future earnings, less dividends.

For firms seeking financial flexibility, less dividends.

Tax considerations: the tax rate on dividends and how dividends are taxed relative to capital gains affect investors’ preferences.

Flotation costs: the costs which make it more expensive to use newly issued stock instead of internally generated funds. Smaller companies face higher flotation costs.

Contractual and legal restrictions: –Impairment of capital rule: a legal restriction on paying dividends if there is not a minimum amount of equity capital. –Requirement of preferred shares.

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY

DIVIDEND POLICY AND COMPANY VALUE: THEORY FACTORS AFFECTING DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY TAX SYSTEM AND DIVIDEND POLICY

TAX SYSTEM AND DIVIDEND POLICY

Consider a company whose tax rate is 35%, and individual shareholders have a marginal tax rate of 25%. Double taxation (U.S.): Earnings are taxed at corporate level; dividends are taxed at shareholder level. Tax rate = tcorporate + tshareholder − (tcorporate × tshareholder) = 35% + 25% − 35% × 25% = 35% + 25% − 8.75% = 51.25%

YI ZHOU CHAPTER SEVEN: DIVIDEND POLICY